Monday, October 31, 2005

Shades of 1987?

A strong Asian economy showing bubble-type characteristics, U.S. bond yields soaring, stocks bouncing around in 1% daily down-then-up-then-down-then up swings, and a new Federal Reserve Chairman to boot.

No, that is not October 2005 I’m describing—that is the summer of 1987.

For those of you too young to recall the sultry September weeks before what at the time appeared to be another Great Crash but was, in retrospect, a mere blip in a Great Bull Market, let me take you back to 1987 with a brief eyewitness account.

The market had jumped by a third in the first eight months of 1987 and peaked on August 25th. Without telling anybody it had peaked, the market began to wobble in a kind of one-step-forward, two-steps-back mode—the result of the Federal Reserve’s persistent interest rate hikes, which provided investors with higher alternate yields to what everybody “knew” were ridiculous equity valuations.

Yet despite the rate hikes, every institutional investor on the planet (including the one I worked at) felt pressure to remain fully invested: nobody wanted to be left behind.

Meanwhile, Japan was in the grips of a stock market bubble and the “smart money” was convinced the Nikkei was going to collapse, which would be the trigger for a U.S. crash—much like today’s concerns about a U.S. real estate bubble and the impact its winding-down would have on the rest of the economy.

And Alan Greenspan had just been appointed as Chairman of the Federal Reserve Board, replacing inflation-fighting Paul Volcker.

As a result, then, like now, stocks experienced wild swings; then, like now, rates were rising; then, like now, all eyes were on Asia; then, like now, nobody knew whether the new Fed Chairman was up to the task of filling his predecessor’s shoes.

The one big difference then versus now was the presence of a wonderfully misnamed financial product called “portfolio insurance.”

Without getting into the details of “portfolio insurance,” which I couldn’t because I never understood the details (although one of the smartest financial guys I’ve ever known had looked into at the time and pronounced “it works”), there was only one downside to the mechanics of the insurance program: when stocks fell, the program sold them.

Which, after weeks of up and down and down and up and down and down price action, is precisely what happened on that grisly 19th of August, 1987.

As far as I can tell, the best thing about the recent week’s up and down and down and up and down and up market is that we don’t have financial institutions loaded up on “portfolio insurance,” which in 1987 turned a normal bear market into a crash.

On the other hand, we do have something we didn’t have much of in 1987—hedge funds, and lots of ‘em.

And with a 1-and-20 fee structure (most hedge funds get a 1% management fee and 20% of any profits), the tolerance for loss on the trillion-dollars or so that they control is very low—because most hedge funds have what is called a “high water mark,” meaning they don’t get paid a bonus for losing money and then making it back.

Furthermore, the institutional investors throwing money at anything called a hedge fund have even lower tolerance for loss, because—unlike the wealthy investors that made up the capital base of the early hedge fund investors—institutions require stable returns, and they are quicker to cut their losses.

Much quicker, as we saw with the convertible arbitrage funds that have shut themselves down this year after absorbing losses which, in the world of equities, could be considered relatively minor.

Just recently, it was reported that a convertible arb fund called Arbitex Master Fund has lost 94% of its assets—from $517 million in January to $30 million at the end of August, with a -13.2% year-to-date investment return.

Imagine what a 13.2% whack in the equity market—which is really nothing too spectacular considering the Dow lost 22% on October 19th, 1987—might trigger among institutional hedge fund investment world.

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.

27 comments:

1. United already filed for bankruptcy protection. That was not the case in 1987.

2. If memory serves me correctly, the then Chairman of the SEC was a U of Chicago "quant" fan who loved to bet the ponies and was very much into promoting options as a hedge. His head of enforcement's jihad was illegal inside trading. I can't seem to recall who the Fed Chairman was in 1987.

3. Drexel was the King of Junk. Now it's Bank of America (BAC:NYSE) and CitiGroup (C:NYSE).

Assuming portfolio insurance in some form is still sought, what form is it taking? Does it invariably involve a counter party? What standards must the counter parties meet?

From the little that I know, Refco had (has?) extensive involvement in the business which requires counter parties. It seems that the Refco situation is a mess (to wit: something which will result in enormous billable hours for Shakespeare's favorite profession.

If extensive counter party positions have been established predicated on reputation alone of the parties, might we be faced with a kind of "cut and run" scenario in which efforts to reduce risk actually result in its aggravation?

I did not take my profit in September 1987. So I lost my profits Oct.19,1987. I did buy a ton of real estate from 1995-2002 and sold a ton of it (180 pieces) from 1999 to 2005. My average profit is 1100% gross and holding only 21months. This time I did not wait for a "crash". This crash will be in the Real Estate Market and I thank George Bush for reducing the Long Term Cap. Gains rate to 15%. Thanks George! Thanks Real Estate market! I'm now a multi millionair that visited over 60 countries in the last 3 years! Complements of the "real estate" market!!

Jeff, I've seen you on television for years and been reading your blog of late, and you're a heck of smart guy, but the 1987 parallel is a pretty ridiculous lay over. Interest rates had gone from like 7 to over 10 back in '87. The dollar was in free fall, it's pretty strong right now. And P/Es were 40% higher, with bond rates 100% higher, making for a much more competitive environment for stocks. And stocks had just gone through a terrific 1985, 1986, and great first 8 months of 1987. Financials were falling apart at the time and they're strengthening now. Maybe you'll be right about a crash, but there's not much evidence of parallels.

By what measure is the dollar strong? We've bounced on the euro, but it's down over five years relative to everything else, our SecTreas is pressuring other countries to loosen up, and the cost commodities in dollar terms has gone through the roof. I disagree with this point.

And P/Es were 40% higher, with bond rates 100% higher, making for a much more competitive environment for stocks.

Agree entirely, especially when you consider inflation (GDP deflator) was about the same in both cases.

The final thing is stocks have gone nowhere over five years. Not exactly a rip-roaring lead-in to an equity market crash.

Excellent observations on high water mark and the portfolio insurance parallel. Very useful, Jeff.

To Dale W, is the dollar up or down this year? It's up over 10% against the yen and euro. In 1987 the dollar index was off over 20% going into the crash. I'm not trying to debate this point, but the direction is what it is, and it's different than 1987.

Nelson is right on about long term rates. I remember distinctly in sept, '87 questioning my stockbroker about " isn't rising long rates bad for stocks? ". He gave me the Hee Haw about earnings, blah, blah, blah. I then bought some of the long bonds which had risen from 6.7% in the spring to 9.375 in early Oct, '87. This Smithers guy has been railing that the Q value of stocks is signaling extreme overvaluation, but its been negative since '91. Maybe it works on a glacial scale in stocks but unfortunately, our investing lives is really only a couple decades or so and anyone following it has lost a tremendous gain in the market since.

"nelson yu": well I'm glad you think so highly of me but television is about as good a medium for intelligent discussion as are Yahoo message boards, so I would discount the value of my TV appearances using a 99% discount rate.

As for interest rates, you are right: long rates haven't gone up much this year...but short term rates--which affect liquidity--have gone from 1% a year ago to 3.75% today and 4% tomorrow after the Fed meeting.

And 1 to 4 is one heck of a rise in rates. If you don't think it matters, call a mortgage broker in Sacramento or Queens and ask him or her what it's done to his business lately.

As for the "crash" scenario implied by my comparison with 1987, I make no predictions. I just offer pattern recognition.

Jeff, maybe your comparison works, but short rates seem to be the only repetitive circumstance. I don't have any market predictions to make, but if you go through the market stock by stock these days, there aren't a lot of parabolic charts outside of energy, and there are ton of very good businesses selling for 11-15 times, all near a 52 week low. Could the market tumble and send all these businesses to 8 times? Maybe. Incidentally, I was chuckling for at least 5 minutes after reading the: see also: Hideki Matsui, Kung Pao Chicken piece!

To Dale W, is the dollar up or down this year? It's up over 10% against the yen and euro. In 1987 the dollar index was off over 20% going into the crash. I'm not trying to debate this point, but the direction is what it is, and it's different than 1987.

Nelson,If the world works on calendar years, I would agree with you, but it doesn't. And just because the price of euros in dollar terms is down doesn't vitiate the point that the dollar price of lots of other goods (e.g. oil) is way up. From the standpoint of what that means for monetary and potential flows, that's bad.

Humph. 1987 will be the model for next year. Pay attention. For those of you who do not understand why long rates have not risen drastically, they will. Greenspan has his staff working on just how to do it without spooking the markets. Read his Jackson Hole speeches. Notice the "puzzlement" over the "conumdrum" of sticky long rates...think about what that means. Say goodbye to the property insanity, say goodbye to a small chunk of the stock market. Notice TOL getting creamed in 2 months from 58 to 36. Think about crashes outside the box- why does a bond market crash never figure into anyone's calculations? Unwind that ridiculous carry trade with Japan....boom. Want to buy a house?

Regarding the dollar, Dale is right that dollar has fallen in the recent years. You really should consider the dollar in terms of various goods, not just against one or two currencies. I like to look at the Federal Reserve Bank Atlanta Trade-Weighted Dollar Index. You'll see that the dollar has been on a downward trend since 2002 when compared to currencies of US's trading partners.

Regarding a possible crash, I would say the problem will be related to those who are engaged in real estate. I'm no expert in real estate, so I have a question. Can you long an asset and buy some type of put-like option on that asset? Or short that asset and buy call-like options? Hmmm... And are there REITs or funds set up like LTCM? I would have to guess that there are, but probably not as large. But taken as a whole... maybe it could have a similar impact. Another LTCM breakdown would not be good.

I would speculate that mortgage lenders that conducted overly aggressive practices will feel the pinch if people start defaulting. Once again, we've neglected that default risk. Oh well.

Hi Jeff - I just came across an article by Alex Schay at fool.com explaining the concept of "portfolio insurance".

After briefly reading the article, my understanding of portfolio insurance is where a trader/institution has a computer program trade like a put option on an underlying asset (i.e. a stock index, for example), where as the price of the underlying asset falls, the program trades out of the underlying asset at a specified price, limiting the amount lost between the actual price paid and the "strike" (for lack of a better use of terminology) as set by the computer program.

One would think that with the proliferation of investment banks (think UBS and J.P. Morgan Chase) and hedge funds using program trading to limit their potential losses, the exchanges (i.e., NYSE and NASDAQ) would devise some type of "circuit breaker" to prevent a 1987-like free fall from occurring if buyers do not appear to mitigate a "tidal wave" of selling by institutional investors (I could be wrong in my understanding though).

Another thing I forgot to mention is about interest rates. As Jeff pointed out, short rates have somewhat risen drastically. The reason why long rates (i.e. 10 year Treasuries) haven't risen accordingly has much to do with 10 year Treasury purchases. Greenspan's conundrum can be briefly explained by demand for such Treasuries from abroad. Asian central banks have bought alot of Treasuries, petrodollars have gone towards Treasuries, and the privatization of Japan's Postal Savings will probably lead to further purchases of Treasuries in the years ahead. Demand from such sources have caused prices of the favored 10 year Treasuries to stay relatively low. Prices go up; yields come down. If these sources for whatever reason stop purchasing Treasuries or even start dumping them, then get ready for 10 year Treasuries to shoot up. Let's just hope we don't end up in a credit crunch situation. I don't like to make doomsday predictions, but you know it's very possible.

What isnt added into the discussion though is the extreme overvaluation of real estate as it relates to other asset classes of the economy. This was present in 1987 but not to this extreme; the pure magnitude of this rise as compared to the runup into the eventual crash of real estate in 1990 is astounding.

The point is not to draw an exact pattern but to attempt to make a hypothesis as to how things might shake out once that extreme overvaluation is taken away, as it was in 1987.

That is exactly the point that's being made here. The correction doesn't appear to be in the stock market, but instead in the overly priced real estate. People here in San Diego have gone crazy. I've seen too many young couples buy property they can't afford using IO financing. Most of these people really don't seem to understand the implications of these irrational purchases. I've noticed how people feel left out in this home purchase trends, and they have bought under the assumption that their property will continue to rise. They tell me that they plan to sell the property before they have to start paying down their principle. I'm like ok... good luck... I'll pray for you.

Some tax plan changes have been brought to the table in Washington. It appears that they are intentionally trying to prick this bubble. Such plans include eliminating the deduction on interest from mortgages, among others. Maybe it's just me, but I feel like I'm waiting for something bad to happen. What better place to witness it then here in sunny San Diego.

There may not be portfolio insurance in the exact form that there was in 1987. However there are many forms of derivatives that will act in the exact same way as portfolio insurance. Which is basically dynamic hedging: selling into a declining mkt, buying into a rising mkt.

One of these is the variance swap sold to large funds that guarantees a payment based on the volatility (or inverse volatility) of the mkt. It allows funds to maintain there positions and lock in the returns to date regardless of what the mkt may do. There is also the total performance swap which is basiccally a highly leveraged put or call option.

The usual cast of characters are selling these (C, BAC, JPM, GS, MER, etc. They are also buyers of similar products. The total value is closing in on $250b notional. What this means in actual values once everthing is netted out is anyones guess, including the Fed (search for 9/15/05 Fed derivatives meeting.

Given the growth and complexity of the derivatives mkt, I'am not comfortable saying that the portfolio insurance issue no longer exists.

Can someone tell me why we don't hear people SCREAMING about the gov'ts' attempt to end the Mortgage Deduction? Who gets hurt, if this goes down? Who doesn't get that this would a tax increase of gargantuan proportions, without being called a tax increase? Yeah, they're trying to pop the bubble, and the people left paying the enormous debt that the administration just keeps adding to? Well, it ain't gonna be the fat cats, now, will it?

Basically, the mortgage interest deduction is proposed to be converted to a tax credit (15% of the interest paid - up to the morgage interest cap). The current cap is something like $1mil, and the proposed cap is to be lowered to around $200k to $300k.

So if you are in the 15% plus tax bracket, and your mortgage exceeds the proposed cap of $300k or so... then you're probably not going to like this plan.

The proposed mortgage cap is actually between $227k and $412k, depending on the region. But there's something else I want to mention. Under the Growth and Investment Tax Plan, (for large companies, except financial institutions) interest paid will not be deductible, and interest received will not be taxable. I guess the gov't is catching on to those tax shelter schemes. Also, if the G&I Tax Plan passes, then (for large companies) new investments will be expensed instead of the currently accelerated depreciation write down – which should create some tax relief resulting from the effectively smaller taxable income… but that would really depend on how they continue to invest in new assets. There are bunch of other stuff; but no matter what, either one of the two plans will cause some noticeable changes to way we do things.

The mortgage interest deduction is arguably the most distortive aspect of the tax code. There is NO reason that the government should be incenting investment into real estate assets vs other assets or God forbid, savings. Home ownership is at approx 70% of households in America. Where does it say that we have a right to life, liberty, the pursuit of happiness and ownership of our own mcmansion? Asset based wealth booms always end poorly, and our government's efforts to promote home ownerhsip at any cost, in concert with the free money policy of Greenspan, has created the mother of all asset bubbles. All the capital flowing to real estate would be more productively deployed in other investment opportunities or in increased national savings that would reduce the current accout deficit, reduce pressures on the dollar and ease concerns about the future of long term interest rates. Any slowing of real estate appreciation would also slow down the unsustainable growth in consumption, which has spiked from 66% of GDP to 70% on the backs of cash out refis and the like. The mortgage interest deduction should be reduced or eliminated as should the implicit government sponsorship of Fannie and Freddie.